How to Catch a Gold Knife

Have you seen gold lately? Where is it trading? How quickly will it get to $2000? Is it too late to get in? These were a few questions I had received from clients who were looking to get long the currency of kings after the S&P debt downgrade. The only advice I had given was to try to buy gold when it goes on sale. At the time, there weren't many who could see through the massive post-debt downgrade move from 1680 to 1900 and realize that it might go down some day. Well, that day has come, and it has left the participants on the long side scrambling for coverage. Even some of the more bullish gold bugs are running for cash as the market sinks like a stone. As the market for gold moved higher and higher, I heard multiple clients express their intentions to "buy on the dip". That dip is here; who's ready to buy?

What? You mean you aren't so sure anymore? The +$200 killer selloff has arrived and your ambition to buy has disappeared? This is the toughest part about trading. Buying or selling into moves takes a psychological conviction along with a solid limited risk strategy. I find most traders can't bring themselves to buy on the dips, especially when they see big moves against positions they would have liked to have had on the books just days earlier at higher prices.

When a market sells off like a waterfall, I feel the option markets offer the best opportunity to catch that knife. I wrote about a similar move in corn a while back and we will apply those same principles in that trade here for the gold market. The futures might offer easier price discovery, but trading futures brings about a big fear of mine called the whipsaw. Nothing is more frustrating when trading a futures contract than getting long a market, seeing the price fall below your stop taking you out of the position, then returning higher than you entered. This is not only a losing trade, it's also a trade where you were correct but weren't paid off. When picking bottoms, or attempting to trade a counter move, the ability to think ahead of the price movements depends critically on risk management. For this type of situation, where I still hold a deeply-rooted belief in gold, I am going do two things to help my chances in successfully buying that dip and staying in the trade.

When executing these trades we need to remember we want to be in for the long haul. Because of the heightened volatility in the market, I would look to the Feb 12 Gold options. These will provide you a lot of time to let the market base around its 100 day MA and turn around. I don't expect Gold to bounce back quickly; I expect it to act like silver, to base and get solid footing around the 100 day simple moving average while grinding higher thereafter. The public suffered some psychological damage from this break and will need time to recover.

The Plan

The first trade we will put on will be to sell a put spread. We will look to do this as the market breaks to its 100 day MA just below 1600. I'd look to sell the Feb 1600 call and buy the Feb 1550 call. As of right now, Gold is trading just over 1700 and a sale of that spread would net 15 points, collecting about $1500. However, I would like to try to sell it for more than that, so we will be patient and place a standing limit order to sell that spread at 25, collecting $2500 in premium while risking $2500 before fees. For conservative traders this might be enough action. On the other hand, more aggressive should look to use that premium to buy an upside call. Keep in mind that by using the premium to buy a call you are raising your max loss on the position from $2500 (set risk from the sale of the put spread) to however much you use to spend on the Gold call. I recommend finding a call that is priced to a place you can afford. If you want to risk $5000 on the whole trade, then look to buy a call for 25 points. This will put you in what is called 'synthetic futures'. Learn more about synthetic long futures

A small difference from the previous example and a true synthetic futures position would be the purchase of our 1550 put. I will never recommend selling naked premium in a market in heavy liquidation mode like we have seen in Gold recently. Remember, the main goal of this position is to be able to stay in this position and avoid whipsaws.

Let's Recap:

• Sell 1 1600 Feb Gold call. Buy 1 1550 Feb Gold Call for a credit of 25 points or $2500
• Buy 1 Feb gold call, spending whatever you feel at whatever strike is appropriate for your risk level.

By purchasing a call we will now have two positions with which we could profit from with unlimited potential as gold rallies. If we see the Gold market continue to sell off we would have a set risk in place so we don't have to worry about placing stops or getting whipsawed. Keep in mind the option strikes can be adjusted to fit your market outlook. The strikes provided are where I feel this market is headed in the short run. I will need to show patience to get filled and risk missing out on the dip if Gold doesn't retrace that much. If you think we may have bottomed or will bottom somewhere else then you should adjust the trade. If you have questions or concerns, contact a Daniels Trading broker; we are happy to consult you.

This type of trade is for believers only. The gold trade is unlike many others because the length that exists in the market place is more convicted than anything I have ever seen. "Get long and stay long," is the attitude of most metals bulls; accordingly, it's going to take more than a 10% decline in the market for them to change their outlook.